NCPA - National Center for Policy Analysis

THE FED'S HISTORIC MOVE

December 18, 2008

The Federal Open Market Committee's (FOMC) action on Dec. 16 was historic in its boldness and its willingness to go further into unchartered waters, says Bob McTeer, a distinguished fellow with the National Center for Policy Analysis and former president of the Federal Reserve Bank of Dallas. 

The FOMC will:

  • Reduce the target Fed Funds rate from 1 percent to between 0 and .25 percent.
  • Use open market operations and other measures to sustain the increased size of its balance sheet.
  • Purchase agency debt and mortgage-backed securities to provide support to the mortgage and housing markets.
  • Take measures early next year to facilitate the extension of credit to households and small businesses.
  • Study the potential benefits of purchasing longer-term Treasury securities.

The only action roughly comparable was the October 1979 decision to target the money supply directly and end the practice of targeting money indirectly by focusing on interest rates, says McTeer.  In fact, the current decision is similar to the earlier one in that it leaves the Fed Funds rate more to the market, in order to hone in on other areas.  The difference is that the 1979 move targeted money and, by implication, bank reserves, on the liability side of the Fed's balance sheet.  The current action seeks to target the asset side of the balance sheet. This is a major shift, says McTeer.

According to critics:

  • The move will be inflationary -- some argue inflation will balloon sooner rather than later.
  • They cite the sharp increase in the size of the Fed's balance sheet and the recent expansion of bank reserves and money measures as prima facie evidence of looming inflation.
  • The Fed's actions will weaken the dollar in foreign exchange markets, which has already begun.

McTeer's response:

  • You don't go directly and immediately from reserve and money creation to rampant inflation.
  • The sharp expansion of the monetary aggregates since the beginning of September was needed to offset the dramatic decline in velocity and the hoarding of reserves by the banking system.
  • Money has to be spent before it can create inflation and before it does that, it will provide a much-needed support to a rapidly declining economy.

The British economist Sir Dennis Robertson made the famous and relevant distinction between "money sitting" and "money on the wing."  U.S. money has been sitting, explains McTeer.

Source: Bob McTeer, "The Fed's Historic Move; Unusual But Not Inflationary," Forbes, December 17, 2008.

 

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